University of Tunis

Tunis Business School

Principles of Finance
Tutorial n°2: Principles of Capital Budgeting
Professor: Dr. Ridha Esghaier
(Spring 2022)

Multiple Choice Questions:

Q1. If a company's required rate of return is 10% and, in using the net present value method, a project's net present
value is zero, this indicates that the
a. project's rate of return exceeds 10%.
b. project's rate of return is less than the minimum rate required.
c. project earns a rate of return of 10%.
d. project earns a rate of return of 0%
Q2.The capital budgeting method that takes into account all the cash flows and the time value of money is :
a. cash payback method
b. discounted payback method
c. net present value method
d. average accounting rate of return
Q3. If project A has a lower payback period than project B, this may indicate that project A may have a
a. lower NPV and be less profitable.
b. higher NPV and be less profitable.
c. higher NPV and be more profitable.
d. no one of the above.

Q4. Which of the following statements is/are not correct concerning the discount payback period, the IRR and the
NPV methods?
a. a project with an Internal Rate of Return (IRR) equal to the Required Rate of Return (RRR) will have an NPV of
zero.
b. a project's NPV may be positive even if the IRR is less than the Required rate of return (RRR).
c. The project’s IRR can be positive even if the NPV is negative.
d. when selecting between mutually exclusive projects, the project with the highest NPV should be accepted
regardless of the sign of the NPV calculation.
e. The Discounted Payback Period is the moment at which the NPV of the project is equal to zero.
f. The discounted payback period is the moment at which the investor earns exactly the rate of return (RRR) he
demanded.

Q5. Which of the following statements is/are not correct

a. The net present value (NPV) and profitability index (PI) yield same accept or reject rules
b. When a capital budgeting project generates a positive net present value, this means that the project earns a return
higher than the internal rate of return.
c. Real options are capital budgeting options that allow managers to make decisions in the future that alter the
value of capital budgeting investment decisions made today
d. In the estimation of the incremental cash flows, financing costs are ignored because both the cost of debt and the
cost of other capital are captured in the discount rate.

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 EXERCISES:
Exercise n°1: Annual operating cash flows. MACRS depr'n.
Your company is considering a new project whose data are shown below. The equipment that would
be used has a 3-year tax life, and the MACRS (Modified Accelerated Cost Recovery System) rates
for such property are 33%, 45%, 15%, and 7% for Years 1 through 4. Revenues and other operating
costs are expected to be constant over the project's 10-year life.

What is the project's operating cash flow during Year 4?

Equipment cost (depreciable basis) $75,000

MACRS rates, years 1-4 33%;45%;15%;7%
Sales $60,000
Operating costs excl. depr’n $25,000
Tax rate 35%

Exercise n°2: Net Salvage value calculation

Big Air Services is now in the final year of a project. The equipment originally cost $20 million, of
which 75% has been depreciated. Big Air can sell the used equipment today for $6 million, and its
tax rate is 40%.
What is the equipment’s after-tax net salvage value?

Exercise n°3: NPV, straight line, constant CFs, working capital

Your company is considering a new investment whose data are shown below. The equipment that
would be used has a 3-year tax life, would be depreciated on a straight line basis over the project's 3-
year life, would have zero salvage value, and would require some new working capital that would be
recovered at the end of the project's life. Revenues and other operating costs are expected to be
constant over the project's 3-year life.
a. Compute the annual cash flows from year 0 to year 3.
b. What is the project's NPV? Should you accept the new investment?
c. Compute the discounted payback of the project. Interpret!

Required rate of return on the project 10%

Net equipment cost (depreciable basis) $65,000
Required new working capital $10,000
Straight line depr’n rate 33.33%
Sales revenues $70,000
Operating costs excl. depr’n $25,000
Tax rate 35%

Exercise n°4: Cash flows estimation

Given the following information, calculate the cash outflows, cash inflows and the net cash flows of
a proposed project.
- Equipment cost = $4,000; estimated life = 3 years;
- The proposed project will initially: increase the accounts receivable by $800, increase the
inventory of raw materials by $600 and increase the accounts payable by $500. The resulting
working capital requirement will increase by 6% annually in the subsequent years and must be
recovered at the end of the project’s life;
- Estimated salvage value = $1,000;
- Earnings before interest, taxes and depreciation of year1 are $2,000 and expected to increase by 5%
thereafter; tax rate = 40%;
- The applicable depreciation rates are 33%, 45%, 15%, and 7%.

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Exercise n°5: Replacement decision
A company is considering the purchase of a new leather-cutting machine to replace an existing
machine that has a book value of $3,000 and can be sold for $1,500. The old machine is being
depreciated on a straight-line basis, and its estimated salvage value 3 years from now is zero.
The new machine will reduce costs (before taxes) by $7,000 per year. The new machine has a 3-
year life, it costs $14,000, and it can be sold for an expected $2,000 at the end of the third year.
The new machine would be depreciated over its 3-year life using the MACRS method. The
applicable depreciation rates are 0.33, 0.45, 0.15, and 0.07.
Assuming a 40% tax rate and a required rate of return on the project of 16%, find the new machine's
NPV.
Should the company replace the old machine by the new one?
Exercise n°6: Payback, NPV, IRR
A company is considering two mutually exclusive projects A and B that have the following cash flow
data.

Year 0 1 2 3 4 5
Cash Flows A -$1,000 $300 $310 $320 $330 $340
Cash Flows B -$1,000 $500 $300 $200 $100 $100

1- What is the Regular Payback Period of each project? Which project should be accepted?
2- Calculate the NPV of the projects knowing that the required rate of return on the project is 10%.
Which project is better?
3- Calculate the IRR of the projects. Which project to retain?

Exercise n°7: impact on NPV of Depreciation and Initial Outlay changes

An analyst is evaluating a regional distribution center. The financial predictions for the project are as
follows:
- Fixed capital outlay is €1.50 billion.
- Investment in net working capital is €0.40 billion.
- Straight- line depreciation is over a six- year period with zero salvage value.
- Project life is 12 years.
- Additional annual revenues are €0.10 billion.
- Annual cash operating expenses are reduced by €0.25 billion.
- The capital equipment is sold for €0.50 billion in 12 years.
- Tax rate is 40 percent.
- Required rate of return is 12 percent.
The analyst is evaluating this investment to see whether it has the potential to affect the firm’s stock
price. She estimates the NPV of the project to be €0.41 billion, which should increase the value of the
firm.
The analyst is evaluating the effects of other changes to her capital budgeting assumptions. She wants
to know the effect of a switch from straight- line to accelerated depreciation on the company’s
operating income and the project’s NPV. She also believes that the initial outlay might be much
smaller than initially assumed. Specifically, she thinks the outlay for fixed capital might be
€0.24 billion lower, with no change in salvage value.
1. Estimate the after-tax operating cash flow for Years 1–6 and 7–11, respectively
2. Estimate the initial outlay and the terminal year cash flow, respectively,
3. Calculate the project’s NPV
4. What would be the effect on the NPV and on the first year operating income after taxes (unlevered
income) of a switch from straight-line to accelerated depreciation?
5. If the outlay is lower by the amount that the analyst suggests, by how much should the project NPV
increase?
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